Credit Suisse’s autocall reverse convertibles on Chevron show best result upon early redemption

By Emma Trincal

New York, July 14 – Credit Suisse AG, London Branch’s 7% contingent coupon autocallable reverse convertible securities due Oct. 26, 2018 linked to the common stock of Chevron Corp. are not designed for income investors seeking a cash-flow stream. While in theory a coupon could be paid monthly through the entire life of the notes, such scenario is the least likely to occur. Instead investors have a much better chance of being called early and to pocket their payout for a limited period of time.

“Given the risk at maturity due to the American barrier, getting the early kick out is probably more desirable in terms or risk-adjusted reward,” said Suzi Hampson, structured products analyst at Future Value Consultants.

Investors receive an annual rate of 7% if the stock closes at or above its 75% coupon barrier level on a monthly observation date, according to a 424B2 filing with the Securities and Exchange Commission. Interest is payable monthly.

The notes will be called at par if Chevron shares close at or above their initial price on a first call date after six months followed by two observation dates on a quarterly basis.

The payout at maturity will be par unless the shares finish below the initial level and close below the 75% knock-in level any day during the life of the notes, in which case investors will receive a number of Chevron shares equal to $1,000 divided by the initial share price or, at the issuer’s option, an amount in cash equal to the value of those shares.

The barrier in this note is “American.” It means that the price of the underlying is observed on a daily basis instead of point-to-point as it is the case with a “European” barrier.

Stress tests

Future Value Consultants produces stress test reports allowing its clients to analyze probabilities attached to a variety of factors and organized in 29 different tables.

Hampson first looked at the “product specific tests” table displaying probabilities of mutually exclusive tests pertaining to this structure. Those are: barrier breach; call at various call dates; and contingent coupon paid in 15 different monthly dates.

The greatest likelihood of being called (53.5% probability) is in six months, or the first call date, the table showed.

The probability of receiving six coupons is about the same at 54.77%.

“The most likely scenario is this 53% chance of calling after six months. It’s likely that, if you’re above the initial price at that time, you’ve also been above the 75% barrier, so chances are you’ll get all coupons,” she said.

The second and third highest probabilities coincide with a call occurring on the second and third call date, respectively, for month nine and month 12.

Those two call dates also represent the two months showing the greatest probabilities of receiving all coupon payments – an 11% probability of getting nine coupon payments on the ninth month and a 7.28% chance to collect 12 coupons on the 12th month.

Paid on the go

“This makes sense. If you are above the initial price on the ninth or the 12th month, it’s likely that you’ve also been above the 75% barrier. It’s not always the case but it’s highly probable,” she said.

She commented on the probability spike on the first call date with more than half a chance of an autocallable event occurring on the sixth month.

“That’s always the case with autocalls. The chances of getting called surge on the first observation date. After that, the probabilities decline,” she said.

The tables showed how highly correlated are the two following outcomes: autocall on the one hand and full distribution of coupons on a given month since day one on the other hand.

The chances of receiving all monthly coupons on non-call dates were much smaller. For instance the probability of receiving seven coupons on the seventh month was only 1.18%. For payments of 10 coupons it was only 1.42%.

“Generally if you call, you get your coupons. It’s much less likely the other way around,” she said.

Barrier and losses

The probabilities of a barrier breach are 20.86%. Another table, the capital performance table, will show a slight difference between this event and a loss event. Such difference is attributable to the American barrier as it allows a breach with no loss at the end if the price finishes positive.

The capital performance tests table examines probabilities for three outcomes: return less than capital, return exactly capital and return more than capital. The “return less than capital”, which is the loss scenario, has a 19.26% probability, which is only 1.6% less than the barrier breach probability.

This means a 1.6% chance of not losing money even if the barrier was hit at some point.

“Investors have an extremely low chance of recovery after a downturn. But it can happen because the barrier can breach anytime but the stock, at least in theory, may go back above 100% by the time the notes mature,” she said.

By definition such scenario would not be possible with a European barrier since the breach is only observed at maturity, she noted.

Another reason for the low likelihood of the “recovery” scenario is the short duration of the notes.

If at some point the stock drops more than 25%, 15 months may not be enough time for a bounce back to the initial level, she explained.

The third outcome does not exist with this product type: there is here zero chance to receive exactly 100% of the initial investment.

Average payoff

On the positive side (return more than capital bucket), the odds of making money are high, with an 80.74% probability. However the average payoff is only 104.6%.

Moreover, this average is calculated for this bucket only. The average payoff in both the win and loss scenarios is a 1.39% loss.

While this average payoff appears disappointing, it has to be put in perspective, she said.

“The chances of generating a positive return remain extremely high,” she said.

“If you compare the 4.6% average return you get 81% of the time, you’re still getting a much better payoff than with the risk-free rate.”

The one-year Treasury yields 1.20%.

Under a bull market assumption, the simulation for the average payoff encompassing all outcomes is higher at 101.15%.

Future Value Consultants also offers simulations based on other market assumptions than its base-case or neutral scenario. Those include bear, bull, volatile and less volatile markets.

Income alternative

“This is a popular structure in general because people look at alternative ways to get income when interest rates are not attractive,” she said in conclusion.

“This note is not hugely risky. Even though the barrier is American, 75% is deep over 15 months. And the underlying stock is not very volatile.”

The implied volatility for Chevron is 18.7% while it is around 30% in the energy sector as measured by the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund.

Pros and cons

“The most likely scenario here is to get six months worth of income and kick out or nine months and kick out. If that happens the product ends. You don’t get all the income but you’re no longer at risk,” she said.

“The unfavorable scenario is to reach maturity. It means you haven’t been called. The barrier has probably been breached at some point and it’s hard to go back up in such a short period of time.

“This report suggests that for investors the best and also the most likely outcome is to kick out.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on July 21 and settle on July 26.

The Cusip number is 22549JJC5.

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